Commodity Prices

The exchangeable value of all commodities rises as the difficulties of their production increase.
~ David Ricardo

Crude Oil as the Next Commodity Supply Shock?

A friend who manages a a good deal of trade of agricultural commodities recently spoke to me about how the increase in domestic oil production has complicated movement of agricultural commodities In particular, he talked about how the boom in oil drilling in North Dakota has made it hard to procure trucks. Trucks are used into North Dakota to haul sand to oil rigs for use in hydraulic fracking and used to haul the oil out of North Dakota toward refineries. One large oilseed processing plant in western North Dakota has had to operate at less than full capacity because it can’t get the trucks and rail cars it needs to operate.

Is oil the next commodity set to experience a supply shock? Natural gas is already there (see past post), with futures now trading at about $2.00/btu as opposed to $10/btu a few years ago. Shale technologies may not result in a comparable drop in crude oil prices, but these new technologies can still compete even if crude oil dipped below $50/barrel. Long term, if the technology continues to progress and can compete with Middle Eastern oil, the world could look different in many ways.

The Bakken Formation, spanning western North Dakota, eastern Montana and into Canada, is thought to be the largest oil deposit in the lower 48 states. It covers 15,000 square miles and holds more than 4 billion barrels of oil. New technologies involving hydraulic fracking and horizontal drilling have made it possible to extract oil from rock as thick as concrete.

The U.S. won’t be alone in tapping new oil supplies. China, currently another major oil importer, has the world’s second-largest store of shale oil. Countries on every continent have shale oil, making oil a ubiquitous commodity that gives every region of the world the wherewithal, at least theoretically, to be energy self-sufficient.

Search the phrase ‘peak oil’ and you’ll find any number of past and recent articles on the sure eventuality of the world running out of oil. Prices may not reflect it right now, but contrary to peak oil ideas, it seems that new technology may leave the world awash in crude oil. For all the bashing fossil fuels take in the media as a non-renewable resource, it seems that they remain throughout history a fuel source with continually replenishing supplies.

So what? Does this matter to agriculture? Certainly it does, as agriculture is an energy-intensive industry up and down the value chain.

At an micro level, changes in energy prices can drive changes in costs and technology. For example, diesel irrigation engines in parts of Nebraska (and likely other places as well) are being replaced this spring with natural gas powered engines because per hour fuel costs will drop from about $12 to under $4. A center pivot in Nebraska will, on average, put on 600 to 800 hours run time each summer. The reduction in variable fuel costs by switching from diesel to natural gas reduces expenses by about $42 per acre or 20 cents per bushel.

At a macro level, changes in crude oil prices will have a significant impact as well. For instance, the economics of ethanol production are liable to be impacted if crude oil prices fall. Given that more than 5 billion bushels of corn are forecast to be used for ethanol production from the 2012 U.S. crop, almost 40 percent of production, there are significant implications if ethanol production is impacted by lower crude oil prices. Corn prices are linked to ethanol prices which are linked to crude oil prices.

It may be unwise to proffer a bearish outlook for crude oil and other commodity prices at a time of a weak dollar and the continuation of low interest rate, easy money policies by the U.S. Federal Government. Commodities are denominated in dollars, and insofar as the dollar remains weak, commodity prices will remain high. As the current market for natural gas depicts, however, supply shocks are eventually reflected in prices, even in dramatic ways.

In the entrepreneurship class I teach we talk a lot about entrepreneurial opportunities. Opportunities for new businesses can arise when changes occur in technology, social values or demographics or in the regulatory or policy environment. A significant change may be referred to as a ‘shock.’

An example of a technology shock is the emergence of the Internet since the 1990s, resulting in opportunities for entrepreneurs to create new companies, new business models, and new wealth.

Alternatively, a shock could be something very specific to an industry. An example from agriculture in the last 10 years was the policy shock of Congressional biofuel mandates, which greatly expanded the opportunity for ethanol production. Use of corn for ethanol production moved from about 1 billion bushels per year to 5 billion bushels in a relatively short period of time, a significant change indeed.

An interesting change that is just beginning to have some impact in agriculture is shale drilling. The technique of cracking open shale rock to release oil and natural gas has spurred many deals in the energy industry. Shale discoveries have reinvigorated U.S. oil and natural gas production. It wasn’t that many years ago that domestic production of either was viewed as in terminal decline. By the beginning of this year, the shale boom has already created a number of new billionaires.

In economics classes we distinguish between moves along the supply curve (changes in supply) versus moves of the entire supply curve (changes in quantity supplied). The distinction is important because a movement to the right in the quantity supplied of natural gas implies bigger long term changes.

At Decision Commodities, we had some risk management products retrofitted for large buyers of natural gas, with our major customers being ethanol plants. During the 2005 to 2006 time period, I distinctly remember the ride with natural gas futures prices going from below $5/btu to about $16/btu. It preceded the big rise in grain prices, and I had never experienced the magnitude of these commodity price changes with a client up to that point in time.

Today, there is a glut of cheap natural gas, and it shows in prices of natural gas, where futures closed last week below $3.00 per btu for the first time since a brief period in 2009, but in reality hearkening back to the period 0f 2002 and prior.

Beyond just lower prices, a shift in the supply of natural gas also creates opportunities, particularly in energy intensive industries such as agriculture. I was reminded of this last week when visiting with my brother, a farmer in Nebraska. About ten years ago he shifted many or most of his irrigation motors from natural gas to diesel fuel. Natural gas prices had risen relative to diesel fuel and it was time to replace aging irrigation motors anyway, so he purchased a small fleet of four cylinder diesel engines that were quite efficient. Fast forward to today and the reverse decision may make sense. Natural gas prices are low again relative to diesel fuel and it’s time to replace some engines. Perhaps it’s time for a switch back to natural gas?

The issue also impacts the cost of nitrogen fertilizers, something important to crop production. The U.S. has suddenly went from a high cost market for nitrogen to one of the lowest cost in the world outside the Middle East. The economics have changed significantly for producers of nitrogen fertilizers as natural gas is by far the biggest raw-material cost for making anhydrous ammonia. The CEO of CF Industries, on of the big anhydrous fertilizer manufacturers, was recently quoted that the company has has moved from a being a high-cost producer by world standards to a low-cost producer. CF plans to spend $1 billion to $1.5 billion over several years to boost capacity at some of its North American plants.

In the U.S. Corn Belt, fertilizer accounts for about 30 percent of non-land production costs of corn, nitrogen the biggest part. While lower natural prices are not yet reflected in prices of fertilizer, over the longer term it will have an impact. If the U.S. Corn Belt gains some advantage in fertilizer prices relative to other countries who export grain and meat products, another degree of comparative advantage in export markets will result.

The impact of shale drilling technology has touched many aspects of the economy and will continue to in expected and unexpected ways. In northwest Iowa, for example, one can hear radio ads for workers needed in the oil fields of North Dakota.

Another example is in major league baseball. In October the Texas Rangers played in its second consecutive World Series. The St. Louis Cardinals won the Series, but the Rangers have certainly enjoyed multi-season success. The Rangers increased player payroll is covered by a new owner, Bob Simpson, whose shale-focused XTO Energy was acquired by Exxon Mobil in 2009 for $25 billion. Play ball!

I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.
~ Friedrich August von Hayek

Agriculture and Macroeconomic Risk

In the previous post, I wrote about commodity price volatility and its implications for agricultural commodities. There is little at this time that points to anything but a continuing period of price volatility in commodities generally, and agricultural commodities in particular.

There is a history of the sort of bearish currency economic environments we find ourselves in currently. They don’t typically end well for agriculture. Before Ben Bernanke and Alan Greenspan were empowered to engineer ‘rescues’ of the world’s financial system, there were other central bankers and government officials that similarly impacted global economies.

A common theme in looking at historic periods of extreme commodity price volatility is that they occur during periods of high government spending and subsequent devaluations of currency through various policy decisions. In today’s monetary policy environment an example is the Federal Reserve’s purchase of U.S. government bonds. Further back in time, an example is the decision of the U.S. government to go off the gold standard in 1971.

I’ll provide historical perspective using corn prices. Below is a chart of average corn prices received by farmers in the United States since 1866. While corn prices vary from year to year based on changes in supply and demand, you’ll notice that substantial changes, or permanent changes in price levels. have occurred rarely, and appear to be correlated with significant monetary policy changes. Click on the chart for a larger view.

Between the Civil War and the First World War, corn prices traded largely between 30 and 60 cents/bushel. The dollar’s value was pegged to gold, as were the currencies of other major economies.

This changed with the outbreak of war in 1914 in Europe. Indebtedness increased for countries involved in the conflict and government finances deteriorated as spending on the war grew beyond all expectations. The gold standard was abandoned by major economic powers, including the U.S., during the war. Inflation ensued and commodity prices increased, including agricultural commodities. Prices of outputs increased faster than inputs, with corn prices more than doubling to $1.45 per bushel in 1918. Farmers in the U.S. enjoyed a period of prosperity that came to be known later as the ‘Parity Pricing’ era. Farm groups would argue in later decades that government policies should aim to return farm prices to levels indexed to those during this time of farm prosperity.

The major monetary issue after the war was how to return to the gold standard, in particular whether to return to prewar values. The U.S., England, and France each chose different paths (Germany its disastrous path also), but eventually each ended up defining their currencies in terms of gold. The U.S. returned to gold at the $20.67 parity from before the war. This move was particularly hard on farmers, as prices of grain and other farm products decreased faster than the cost of inputs. The average price for corn received by farmers fell from $1.44/bu in 1919 to $0.54/bu in 1920. A prosperous time in agriculture came quickly to an end, even while the rest of the U.S. economy quickly adjusted and went on to a decade-long period of growth.

The Roosevelt administration didn’t abandon the gold standard, but did devalue the dollar relative to gold in 1934. At the same time U.S. corn prices rose from $0.49 in 1933 to $.80 in 1934.

It wasn’t until the end of World War II, however, that saw the next significant change in commodity prices. At the end of the War the U.S. and other winning powers adopted what became known as the Bretton Woods Agreement, a gold/dollar standard. Corn prices briefly rose to the $2/bushel level in 1947, but as adjustment to new dollar valuation settled in, corn prices moved into a range between $1.00 and $1.50 per bushel during the 1950s and 1960s.

In 1971 the Nixon administration abandoned the gold standard of $35/oz. Government spending in the U.S. had risen rapidly since the mid 1960’s, a consequence of the Vietnam War and Great Society social program spending. This put pressure on the existing dollar valuation in terms of gold, and the era of floating currency values began. Corn prices, as well as other commodities like oil, rose in tandem with the decrease in the value of the dollar. In 1974, the rise in commodity prices coincided with a surge in corn exports, and the average bushel of corn sold in the U.S. went for $3.02/bushel. The U.S. suffered inflation through the rest of the 1970s, but new, higher trading ranges for commodity prices had been reached. Corn traded largely between $2 and $3 per bushel until around late 2006.

What’s changed in terms of monetary policy in the last decade? Corn has traded in the last two years in a huge range, between $4 and $8 per bushel. Crude oil has traded largely above $80/barrel.

The macroeconomic environment since 2000 (bursting of the tech bubble) and 2001 (September 11) has been one of near-zero interest rates. This has led to a weakening in the value of the dollar. Commodities are priced in dollars, so the lower the value of the dollar, the higher the price of commodities. In 2000, one dollar purchased 1/270th an ounce of gold and 28 pounds of corn. In December 2011, one dollar purchases 1/1,700th an ounce of gold and 9 pounds of corn.

Some economists argue that dollar depreciation hasn’t been that severe and do so by noting the smaller changes in the value of the dollar relative to other currencies. I argue that most currencies have depreciated alike, with most governmental monetary authorities following similar cheap currency/loose money formula for the last period of years.

Periods of high government spending are historically in tandem with periods of currency debasement. It takes many forms, but the idea is that governments have an incentive to pay back debts and/or fund continued spending in lower valued currency. Periods of war from history have the common thread of high government spending followed by currency manipulation and subsequent inflation.

War and defense spending plays less of a role in government expenditures today, but social programs have driven government spending levels, as a proportion of GDP, to historically high levels along with government debt. The current situation in Europe mirrors historic instances where high government spending leads to a series of unpleasant choices with currency devaluation coming in line before austerity.

The average price received by U.S. farmers for a bushel of corn in 2011 is pegged by the USDA at $5.90/bushel, an all-time high. Prices have backed off in the last several months, but is there any reason to expect prices to retreat significantly? It wouldn’t seem so, particularly during a week when the U.S. Federal Reserve agrees to provide dollar liquidity to European governments facing their own problems with unsustainable government spending.

If anything, corn appears cheap compared to other commodities, gold for instance. Since 1980, it’s usually taken 100 to 200 bushels of corn to ‘buy’ an ounce of gold. Today, that number is at about 350. Perhaps gold it too high, but in the current environment, I think most spread traders would be long corn and short gold, betting on a narrowing of the spread.

My biggest concern related to macroeconomics and agriculture is related to my earlier assertion that these sort of events don’t typically end well for agriculture. Periods of currency devaluation result in asset and commodity price inflation. The front end of these times can often be positive for agriculture, particularly for producers, as prices rise faster than costs. The back end of these times echo back to the 1920s, late 1940s, and early 1980s, not good times for agricultural producers.

In 2007 I had an agribusiness executive who was nearing retirement tell me this was the third promised ‘golden era’ of agriculture in his career. The first in the 1970s, the second (very brief) in 1995, and now the third. A combination of market reactions and political changes can eventually change the macroeconomic environment that shifts the prices by which we buy, sell, and invest in unexpected directions and magnitudes. A significant shift in macroeconomics promises a significant shift in the agricultural business environment as well.

Money is the representative of a certain quantity of corn or other commodity. It is so much warmth, so much bread.
~ Ralph Waldo Emerson

Commodity Price Shocks and Agriculture

I spoke to the Ag 450 Farm class two weeks ago about agricultural marketing. It is the only completely student managed farm at a land grant university in the United States. I always find it a great experience to meet with the class, and enjoy visiting about decision making in pricing crops in the context of risk management. As with all things at the Ag 450 farm, it’s not a theoretical classroom exercise, but real.

The issue in front of the marketing group in the class this Fall is the same one facing farmers, namely the $1.50 per bushel drop in old crop corn prices and $1.00 per bushel drop in new crop corn prices since September. The challenge is particularly acute for the class, as well as farmers, in thinking about forward marketing a portion of the 2012 corn crop when forward cash bids are now below $5.00 per bushel in central Iowa. What’s the upside potential? What’s the downside, particularly as the market moves closer to breakeven points? It’s more fun to make sales at levels $1 or $2 per bushel above cost of production, something most farmers experienced on at least a portion of their 2011 production.

The point for discussion with the Ag 450 class was about decision making in the current market environment. Of course this includes timeless guides like knowing your break-even price and making pricing decisions based on it. A larger discussion ensued, however, about the the challenge of grain and agricultural commodity prices being hitched so closely to other commodity prices and economic events globally.

If you can predict the likelihood of how events play out within the European monetary union, for example, then perhaps you can predict where corn prices will trade. Right. No problem.

For the last ten years all commodity prices, to varying degrees, have experienced levels of variability not seen since the 1970s. Analysts for any of those same commodities can provide a list of reasons as to why. Middle east upheaval. Growing demand from China. Weather events. The list goes on, but the results are the same. Commodity prices have continued to drift upward, with accompanying increased in volatility.

The CRB index tracks the prices of a basket of about 20 commodities, including agricultural, energy, industrials, and metals. With a notable hard break in the Fall of 2008, the CRB index has continued upward.

What does this mean for agricultural commodities? It implies a continuing period of volatility.

The macroeconomic environment since 2000 (bursting of the tech bubble) and 2001 (September 11) has been one of cheap money and near-zero interest rates. This has led to a weakening in the value of the dollar. Commodities are priced in dollars, so the lower the value of the dollar, the higher the price of commodities. In 2000, one dollar purchased 1/270th an ounce of gold and 28 pounds of corn. In November 2011, one dollar purchases 1/1,700th an ounce of gold and 9 pounds of corn.

Some economists argue that dollar depreciation hasn’t been that severe and do so by noting the smaller changes in the value of the dollar relative to other currencies. I argue that most currencies have depreciated alike, with most governmental monetary authorities following similar cheap currency/loose money formula for the last period of years.

Will corn prices go up or go down? Flip a coin for the answer. I think the more important question is whether they go up or go down by $2 or more? In an upward direction this implies high profitability. In the other direction it implies significant losses.

For those with agricultural commodity price risk it implies a reward to discipline. A preordained discipline for covering breakeven is important no matter the method. I think it also implies a value to buying options, perhaps well-considered and timed purchases of both calls and puts. Risks of extreme price movements, up and down, place more value on being long options rather than short. There’s a cost to a long options strategy, but the current market environment, extreme variability, favors it.

There is a history of the sort of bearish dollar economic environments we find ourselves in currently, and they don’t typically end well for agriculture. In a future post, I’ll provide some context on this history.